TABLE OF CONTENTS. I Welcome to Tradespoon 3. II Advanced Options Strategies 33

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2 TABLE OF CONTENTS I Welcome to Tradespoon 3 1. How to Find Trades 4 2. A Simple Strategy for Monthly Income 6 3. Daily Updates and Tradespoon Picks 8 4. Five Secrets of Successful Investing Why Trading Options Call Options Put Options Core Principles Calculation Risk Picking the Right Strike Price Choosing the Right Expiration Date Getting Started 32 II Advanced Options Strategies Bull Call Spreads Bull Put Spreads Bear Call Spreads Bear Put Spreads Butterfly Spreads Condors Calendar Spreads Selecting the Right Strategy Earnings, Earnings, Earnings Unusual Options Activity Advanced Options Strategies: Volatility Rank Historical Vs. Implied Volatility How to Look at Volatility Volatility Skew Time Skew Delta Theta Vega Gamma 72 1

3 III Developing a Trading Plan Introduction to Technical Analysis: Trend Support Resistance Fibonacci Retracements Why are Bollinger Bands Important Oscillators: Envelopes RSI and Moving Averages Statistical Analysis Seasonality Chart Patterns: Rectangles Triangles Flags Predictability and Statistical Analysis Day Predictions Day Predictions Correlations Probability Calculator Portfolio Management: Sharpe Ratio Understanding Portfolio Beta Sector Diversification Position Delta Position Theta Entry and Exit Points Build Your Monthly Return Goals How Much Slippage? Trading Psychology How to Get 5% Returns Per Month Margin Requirements Options Requirements Monthly Account Value How to Place a Stock Order Options Orders Spread Orders Assignment Risks What to Do at Expiration 135 2

4 I - WELCOME TO TRADESPOON We want YOU to trade smarter. To that end, this book you re reading offers a glimpse at our friendly Trade Intelligence Platform and how it is used to find high quality, high return trade opportunities typically reserved for the elite. After reading the first 30 pages, readers have a basic understanding of options and better understand how Tradespoon tools fit into a longer-term trading plan. The subsequent two sections cover: II) Advanced Strategies and III) Developing a Trading Plan. Our goal is to help you become a smarter, more successful, investor and build greater wealth for you and your loved ones. Please feel free to send follow-up questions to: info@tradespoon.com Smart Trading! 3

5 1 HOW TO FIND TRADES Learning about stocks and options is a first step in becoming a successful investor. In addition to understanding trends in the overall market, concepts like volatility and how a stock can move from earnings to earnings cycle are important elements to understand. Also, you want to know which stocks make the best candidates for buying and selling. Tradespoon assists you with the help of a proprietary technologies called Tradespoon Trade Idea Tool and Seasonal Charts. TRADESPOON TRADE IDEA TOOL Tradespoon Trade Ideas combines both fundamental and technical analysis to forecast the probability and predictability of each stock for next day or for a specific period of time. We do this by analyzing over 8000 stocks that trades at NASDAQ, New York Stock Exchange, and AMEX. We assign probability and predictability depending upon whether their value will increase, decrease or remain static for the period in question. Figure 1A - Tradespoon Trade Ideas - Bullish! Figure 1A shows Tradespoon Trade Idea searching for stocks with bullish outlooks and expected to move higher. The tool provides a daily list of stocks that are ideal for trading to the upside, based on the predictability and probability of the stock value being higher. For instance, 4

6 in the case of Hasbro (HAS), we see that based on our algorithm, the trend is upwards. Score of 9 means that there is high probability that the stock value will increase throughout the next 50 days. 10 is the maximum score possible. SEASONAL CHARTS Seasonal Charts can help you foresee the future of a stock by looking at previous price action. The charts are based on independent models. They provide short-term price predictions and key support and resistance levels. In Figure 1B, the orange line indicates the predicted price for the next 10 days, the blue line indicates the actual price of the stock during the year, and the green line indicates the predicted stock price over the years. In this example, overhead resistance for AAPL is at $ This is a bear instance and you should sell! For the next day, the support shown by the red line is at $ , which indicates a short term buy signal! Figure 1B - Seasonal Chart for Apple 5

7 2 A SIMPLE STRATEGY FOR MONTHLY INCOME There is a fifty-fifty chance of making money if you buy a stock. It might go up or it might go down. Trading options, on the other hand, can reduce your cost basis and, if you trade small and trade often, you can be correct 60% of the time or better! As a result, if you can structure your portfolio and build your trading plan such that you are correct 60-70% of the time, you can steadily grow your portfolio on monthly basis. Options spreads are an important part of what we do. Although spreads limit your upside, their limited risks help to withstand short-term volatility in the market. Spreads are simple to learn and can be Figure 2A - Profits and Losses from Options Spreads executed over and over again on a monthly basis to generate a monthly income. Spreads work well with Tradespoon tools like Stock Forecast and Probability Calculator, without having to be 100% accurate on predicting direction. Tradespoon technology works best by selecting 50 to 75 days until expiration, so you have to ascertain the Option Expiration Month. If this is a tad confusing now, don t worry, we cover the details of picking expiration months in subsequent chapters. Also, it is important to learn Volatility Ranking and how options behave, as implied volatility changes before the earning season and after the earning season. This too is covered in our discussion of Advanced Options Strategies. Since you are improving your Probability of Success by 60-80%, it is very important to trade small and trade often to make sure that you do not sustain substantial losses when there 6

8 is a market sell-off or short-term volatility. The concept of Maximum Draw-Down, which is basically how much you can tolerate losing at once, is important in this context. Spreads are limited risk/reward positions. For instance, Figure 2B shows a risk graph for a strategy known as a Call Spread (covered in Chapter 13). The profit and loss along the y-axis and price of stocks along x-axis. The maximum loss is at point A and maximum gain is at point B. The Breakeven point is where the y-axis of profit and loss intercepts the blue line. Figure 2B - Spread Trade Risk Graph In a bull call spread, when the stock price goes up, you are making more profit and vice versa. We will see in Section II on Advanced Strategies that different spreads have different sloping risk graphs. Bull call spread is one we use quite often. 7

9 3 DAILY UPDATES Tradespoon develops technology to help you learn what stocks to trade, the direction of those stocks, whether they move up, down or stay static, and at what price to buy or sell a Stock or option. On a daily basis we send an that provides all of the information. Figure 3A Daily Mail and Video Subscribers also receive 15 to 20 minute videos daily that explain the theory of how to trade using the Tradespoon technology. A list of Trade Picks for the day using various Tradespoon Technologies are also included, as well as a list of open positions. Tradespoon has a live account at the firm Trading Block where we execute these trades daily. We also note all adjustments we make to positions. Lastly, the contains a list of upcoming webinars for the week. 8

10 TRADESPOON PICK The daily includes a Tradespoon Pick of the Day. A video and an analysis report from our analysts describe the fundamental and technical aspects of the pick. Entry and exit prices for both Stock Trade and Options Trade are provided. Experienced traders will find entry and exit prices for more advanced strategies such as the Option Spreads, Calendars, or Butterflies. Figure 3B - Tradespoon Expert Picks Proprietary Tables with our Expert Picks (Figure 3B) are included and show Support and Resistance Levels, technical indicators like Fibonacci Retracement, and important events such as earnings announcements. It shows you news and commentary, what major events occurred for a stock, like Disney in Figure 6, and what happened during those past earnings announcements. The table also includes Probability Calculator, the probability of a stock reaching a certain price point by the expiration of the pick, and a short term predictions for 1-10 days. Subscribers get a total of 22 picks a month. 9

11 4 5 SECRETS TO SUCCESSFUL TRADING To be a successful trader, whether you are a day trader, beginner or professional, the starting point is to develop an outlook for the overall market. Is the stock market is in an upward trend, downward trend, or in a trading range? The second step is to know whether the assets you are trading, whether it s a stock or an option, is Bullish, Bearish or Neutral Bias for the time horizon that you are trading. The third step is understanding Support and Resistance Levels for the time horizon that you are trading. That is, knowing what the Buy Signal and Sell Signal are by looking at the Support and Resistance Levels. The Tradespoon Stock Forecasting Tool can help. 10

12 STOCK FORECAST TOOLBOX Tradespoon s Stock Forecast tool is designed to predict or anticipate how a stock's price trend is moving in the short and long-term future. It relies on mathematical formulas of neural network technology, digital filtration and statistical spectral analysis for the final decompression of company trend from market noise. The Stock Forecast Tool allows a computer to attain information from a historical set of data, find a mathematical pattern and predict stock s price trend for a time period of 10 business days up to 6 months. The goal is to maintain predictions with the highest possible accuracy. Figure 4 shows the 10-day forecast for EMC and expectations that shares will trend lower. Figure 4 - EMC Short-term Forecast 11

13 The fourth step is to have a correct trading strategy. For example, if you buy a stock, there is only fifty-fifty chance of it going up and a 50% change of it moving down in the next minute or day. If you trade options, you can increase your Probability of Success to 70-80% based on your risk tolerance. Also, options allow you to improve the cost basis and pay less than buying shares outright. The final and most important step is your psychology. Having a concrete trading plan can help you overcome the emotions when a trade turns against you. It s important not to act out of emotion but remain rational and follow the trading plan. Trading Psychology is covered in-depth in Section III. WHY TRADESPOON? In summary, Tradespoon provides you with daily recommendations to help you follow our guidelines and become more successful. Seasonal charts show you what the future looks like for the stocks, in terms of how the stock acts today and how it has behaved for the past 25 years. And, is there any correlation between historical price movements and current price movements? We predict the support and resistance levels for next day to up to the next 75 days. We show you Probability Calculator that tells the probability of the stock reaching a certain price point by a certain time range. If you are trading stocks, we highlight the best candidates for trading and identify optimal entry and exit prices. If you are an options trader, we suggest how to execute a call or a put, and if you are spread trader, we tell show you the best options to trade. According to our statistical analysis, it is important to trade small and trade often as it increases the probability of success, just as the chance of a 7 coming up more often when rolling two dice. Also, it is equally important to follow guidelines in calculating the Return on Capital and knowing when to get in or get out of a position. More on this in Section III. Now let s talk options! 12

14 5 WHY TRADE OPTIONS? Are you finding it difficult to generate income buying and selling stocks? Well you are not alone! That s why many traders turn to specific options strategies to set up higher probability/defined-risk trades specifically designed for markets just like this. TRADING OPTIONS Although many investors buy and sell stocks, it s hard for them to make the transition into options. One reason, perhaps, are the many misconceptions like options are too complicated or risky. The truth is that puts and calls and provide certain advantages over trading single stocks and can reduce risk. It s important to at least learn what the advantages are, and then consider augmenting your portfolio with options strategies. If you can create a hedge for your portfolio or if you can generate a steady income by trading options against the underlying stock, you can greatly improve your monthly returns. So, let s see what those advantages are. First, options allow cost basis reduction. For example, if you are planning to buy shares of Apple at $135, you can execute an options strategy, and get the same stock at a reduced price of, say $130. By using options you can usually get 1 to 3 percentage cost reduction for the underlying asset that you are trading. This in turn can help in improving your Probability of Success to more than 75%. As seen earlier, trading a stock is a binary event and has a chance of increasing or decreasing in value. It is like the flipping a coin, which has a half-chance of either happening. Stock market being a system of random events, even with all the fundamental and technical analysis, you cannot accurately predict the random events affecting the market. But with options, if you can buy an underlying asset such as a stock at 2-3% cost basis reduction, you are 13

15 right away improving your Probability of Success and making it better than the half-chance. This is a significant edge that you are gaining. So, even though options could be directional trade, they can also be a market neutral trade. And, if you look at the Statistical Analysis, you will find that by trading small and trading often, and doing it over and over again, month after month, you will see an improvement in your portfolio compared to trading stocks alone. It also allows you to leverage your capital. Consider an average trading account with $10,000. It can t buy a stock like PriceLine (PCLN) that trade at $15,000, or can only buy one share and try to sell it for more than 10% of your account. So, it becomes difficult to participate in great stock like Alphabet (GOOG) or PriceLine. But if your stock has underlying options, you can always participate in these great trades as options trade at a fraction of the stock price and therefore provide greater leverage. You can limit your risk with options as well. The most frustrating thing as a trader is when, even after being correct on the direction and timing of the market, you still sustain losses in your account due to short-term volatility. By trading options, you can limit your downside by allowing yourself to withstand Short-Term Volatility. You can sometimes have unlimited upside if you trade in options. So in effect, options can give you limited loss and unlimited gains! The fundamentals of options trading are easy to learn too. EXAMPLE Let s look at an example. The first thing when you try to delve into the world of options is a call option. What is a call? A call gives you the right to buy an underlying asset at a certain price point in the future. Think of it as you want to buy a house and the house costs $250,000, but you don t really have money to buy it now! You will be able to afford it in 6 months though. So, if are able to go to your landlord and say I can buy this in 6 months at the current price and he agrees. Wouldn t that be great! This is a call. A call option allows you to buy underlying assets in the future at the current price! You pay a price, called a premium, for this option. In Figure 5, the x-axis shows the price of the underlying asset and y-axis is the profit/loss. The value of the underlying asset, or profit, is increasing as the price moves higher. The strike price is the value of the underlying asset at which we make the Call. For example, the value of 14

16 the house at $250,000. Since there are often many to choose from, selecting the right strike price is very important and covered in more detail later. Choosing the optimal expiration month is significant as well. Figure 5 - Long Call Risk Graph Just like an insurance policy, an options contract has a certain time duration. Insurances are usually bought for one year after which it expires and has to be renewed. Similarly, options too have to be renewed after they expire. However, an option can also be closed or offset any time prior to expiration as well. Lastly, the breakeven point is the point at which x- axis meets y-axis. It s the point at which the price of the underlying asset meets profit/loss. 15

17 6 CALL OPTIONS There are two types of options calls and puts. Let s talk about calls first. A call option is a contract that gives the holder the right to buy (or call) an asset at a certain price within a specific period of time. The holder pays a price, or a premium, for the right to enter the contract. The seller collects the premium for selling or writing the call option. One call controls 100 shares and the price paid is the quoted price for the option, multiplied by 100. Suppose you want to buy a house and the average house costs about $250,000 in the United States. But, since you can t afford it at the moment, you want to postpone the purchase for 6 months. You propose to the landlord to rent you the house for 6 months at the end of which time you will buy the house for say $250,000, which is a fair market value for it at the moment. This is an example of call option, where you can postpone the purchase of an underlying asset by pay a counter such as rent to the holder of the underlying asset. As shown in the graph, as time goes by between now and 6 months, your profit will fluctuate in the same way the underlying asset price fluctuates. Figure 6 - Long Call Risk Graph 16

18 CALL ATTRIBUTES There are a number of attributes or terms related to call options. Strike Price is first. As you can see in the profit loss graph in Figure 6, you will have a limited loss at $200 and potentially unlimited gains once the stock goes above the $40 level. So, it is very important to select strike prices using predictive analytics or technical analysis. Selecting the best Expiration Month is equally important. Again, as you can see in the graph, the stock has to move from $40 to $50 by a specified time. If you are not correct on the time, you might not benefit from the upward movement of the underlying asset. Also, you need to be comfortable with the option price. How much uncertainty is in the market and how does it affect the underlying option? Options, just like insurances, are derivatives. So, the premium will go up when there is uncertainty in the market and it will go down when there is less uncertainty in the market. These concepts are covered in more detail in our chapters on Implied Volatility. Assignment and Expiration are can sometimes result in losses. If you face Assignment on an option that you wrote or sold, especially if your contract is in-the-money, you might sustain substantial losses. So you have to be careful and close your option contract prior to expiration or pay attention when the broker dealer assigns you on an option, which results in Short Stock (puts) or Long Stock (calls). Close the position as soon as possible in order to avoid losses. Expiration is also very important as this is where you might want to close the position because if you don t, the option can move very similar to shares as you move closer to expiration. The concept of moneyness is also important to understand. An option is either In-The- Money, Out-of-The-Money or At-The-Money. ATM calls have strike prices equal to the stock price. ITM calls have strike prices below the current stock price. Options with strike prices above the current stock price are OTM. 17

19 POINTS TO REMEMBER Time Range Selection: If the Stock does not move from $42 to $50 within the time you selected, your options will expire worthless. This is the same scenario of taking insurance on a house. If nothing happens to the house, which is actually a good thing, you will lose the premium you paid to the insurance company. Insurance companies are so profitable because most of the time nothing happens to the house and they are able to collect premium without having to pay anything. Directional Bias: In order to be a successful trader, you have to have Directional Bias. If you are buying a Call, you should have an Upward Directional Bias. You expect the stock to increase in value so that you can make money out of it, even though the exact extent of increase is unknown. Volatility: High Volatility means high uncertainty, which will typically means you pay high prices for options. Leverage: An average retail account in United States is $10,000. For such an account holder, it might be impossible to buy a stock like PriceLine that trade at $15,000. Options allow you to leverage capital and make such trades possible. Risk vs. Probability of Success: Keeping in mind these two aspects will make you a more experienced and confident trader. The higher the Probability of Success, the higher will be the risk involved. Once you get more experienced, you will learn to trade so that you have higher a Probability of Success, while at the same time able to aggressively defend your positions when a stock or market goes against you. 18

20 7 PUT OPTIONS A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Insurance is a classic example. If you buy insurance on a house worth $250,000 because you fear something happening to it, then you can buy an insurance policy to ensure that the value doesn t drop beyond a certain level. The premium paid to the insurance company to protect a drop in value below $250,000 is what we call a put. In the case insurance, the time period is one year and you will have to renew it each year. Figure 7 - Put Option Risk Graph As you can see from Figure 7, the profits and losses change as the price of the underlying moves higher and lower. The insurance or Put will go up if there is more uncertainty in the market, or if the underlying asset will go down in value. The price of the Put will go down if there is less uncertainty in the market or if the underlying asset increases in value. 19

21 PUT OPTION ATTRIBUTES Similar to call options, there are a number of attributes or terms related to puts. Again, the first is Strike Price selection. In the case of an insurance, the Strike Price is the value at which you want to sell your house in case of an event in the future. You also have to select the Expiration Month which determines the duration-in the case of insurance it is one year. For options it can be weekly, monthly or quarterly according to your convenience. And you also need to be comfortable with the option premium. You can use the binomial equation to determine the option price going into the future. For a put option, the price goes up when the underlying asset decreases in value, or the Implied Volatility increases, or the interest rate or dividends increases. All these attributes are figured in the binomial equation for determining the option price. Keep an eye on Assignment and Expiration. If you are going to get assigned on a put that was sold and if the price of the short stock goes up suddenly, then you will lose money. In Figure 6, x-axis represents the price of the underlying asset and the y-axis represents Profit/Loss. As the price of the underlying asset goes down, your profit increases. But if the underlying asset or underlying goes up in price, you are going to lose money. If you own a put, the contract loses value over time (all else being equal) and the losses are limited to the premium paid. So you have to aware of the expiration too, as the option ceases to exist after it expires. The concepts of in-the-money, at-the-money, or out-of-the-money apply to puts as well. An at-the-money put has a strike price equal to the stock price. An out-of-the-money put has a strike below the stock price. A put with a strike price above the stock price is ITM. Once you get more comfortable with these concepts and become a more experienced option trader, you will realize that selling out-of-the-money options makes more sense because the Probability of Success will increase and you can be correct 70-80% of the time. We will see why in Section II. 20

22 POINTS TO REMEMBER Time Range Selection: If you buy insurance on the house, it is for twelve months or one year. If you are trading in Apple earnings, and Apple earnings is going to happen in a month, you will have to trade in options that expire in more than a month s time. Directional Bias: You have to have a directional bias in order to be a successful trader. A put purchase represents a bearish directional bias on the underlying asset. Volatility: High Volatility means high uncertainty, which will mean you will have to pay higher premiums for options. You have to learn how Implied Volatility works for an underlying asset. If you are approaching a binary event and you have uncertainty in the underlying asset, the Implied Volatility will go up and so will the price of the put option. Hedge: You can use Puts as a hedge mechanism. Suppose you have an underlying Stock or an underlying house and you want to buy insurance, then you can purchase puts. One put hedges 100 shares. Risk vs Probability of Success: As you get more experienced, you will realize that it makes more sense to sell out-of-the-money puts when you are bullish as this will reduce your cost basis and improve your Probability of Success. Also you will learn to be more proactive in defending your position when needed. 21

23 8 CORE PRINCIPLES What are the Core Principles behind trading? Are there certain rules that successful investors follow? Yes! For every trade recommendation made by Tradespoon, subscribers receive an e- mail with a Trade Pick. It has different key elements to understand before trading. The first one is the implied volatility or IV Rank, which is the volatility change (and we cover in more detail in Section II). Implied Volatility Rank shows you relative IV, that is, today s Implied Volatility versus that of the past 52 weeks. It gives an idea of whether to buy an option when cheap, that is when volatility is cheap, or to sell an option when expensive, that is, when volatility is elevated. The second key element is the Return on Capital (ROC). Return on Capital helps you determine when to enter or exit a position. Make sure to calculate Return of Capital prior to executing an order or getting into position. It determines at what point to exit the position. Buy and hold doesn t work well with options. So, if you plan to get into a position, by buying Low and then wait to sell high, you have to know the exact point to Exit the position. The third element is Probability of Success (POS), which shows you the Risk versus Return for you or the position. It is calculated using the Probability Calculator that shows the probability of Stock being at a certain price level at a certain time. The next element is the Estimated Move (EM). EM shows, with a high degree of mathematical certainty, at what range will the stock trade based on underlying data, by the time the trade recommendation or option expires. Options data shows demand and supply in the market for the specific options during the operation months, and hence can be used to determine the trading range of the underlying stock. 22

24 Figure 8 - Price Data for Dow Chemical The final element is prediction of what the Support and Resistance for the next 10 days. As we can see in Figure 6, if today is April 23rd, we will show you what we think will the High and Low be for the next 10 days-that is for April 24th, 27th, 28th through May 7th. In the graph, if you look at the lowest price point for the Lows and the highest price point for the Highs, it will tell you what the Price Range and Support/Resistance for the trade recommendation for the next 10 days, as seen in the example for Dow Chemical (DOW). 23

25 9 CALCULATING RISK Tradespoon provides you with different tools to calculate risk. Probability Calculator is one such tool. It helps determine the risk by showing you the Short-Term Support and Resistance levels. It also shows the probability of a stock reaching a certain price point by the expiration date. Probability Calculator is very important for both stock and options traders, as it gives you a statistical analysis of the stock being at a certain price point. One standard deviation on Probability Calculator (PC) is really basic statistics. When trading options, you will often hear that you are looking for 30% gain between the strike prices of a spread, or whatever the strategy that you are executing, you usually want 30% gain between the strike prices, which means you are looking for roughly 68% chance of being correct. So basic statistics is very important that means you want to know the odds of the trade in order to be successful. HISTORICAL VS. IMPLIED VOLATILITY Two other tools are Historical Volatility and Implied Volatility. Historical Volatility shows how the stock has behaved in the past and how volatile the stock has been over previous time frames like 20, 30, or 100 days. Historical Volatility is a measure of the volatility of the underlying. It can be thought of as the speed or rate of change of the underlying stock price or how often does the stock price change. The higher the Historical Volatility, the higher the rate of change and hence the more the risk involved with the underlying asset. Implied Volatility on the other hand, predicts what the future performance of the underlying stock is going to be and can be used to predict where the Stock is going to be in future. Implied volatility is a function of an option price and is backed out from the price using 24

26 a model or calculator. Implied Volatility shows you the expectations of future volatility and can be thought of as the uncertainty of the underlying asset. You can use different models, such as binomial model or binomial equation, to predict Implied Volatility based on prmiums. You can also look at dividends and other attributes such as the interest rate. As you approach earnings, Implied Volatility will expand due to the future expectation of what will happen to the underlying asset. In order to be a successful trader you have to study movements of Implied Volatility and learn how it changes between the earning seasons or between different binary events. You can see both Historical Volatility and Implied Volatility in Figure 9A. Figure 9A IV and HV Graph The most important concept that Tradespoon advocates on every trade recommendation is Higher Return on Capital means higher risk! By using the Probability Calculator you can structure your trade accurately 80% of the time and you can be right 90% of the time by selling the out of the money options. But this comes at the price of taking High Return on Capital. So, you have to be very aggressive in defending your position and in making sure that the trade doesn t go against you. Just like everything else in life, there is no magic! 25

27 PROBABILITY CALCULATOR Probability Calculator found on Tradespoon.com will show you the probability calculated of models and predicts stock prices based on the Options Expiration Cycle, which is very important to options traders. Probability Calculator will show Support and Resistance prediction for the next 50 days. If you are a weekly trader, you will be shown the Support and Resistance for the next 5 or 10 days. It will also show a Trend value, and a Buy/Sell Rating, which shows the probability of the stocks being higher or lower and how predictable the stock behavior is based on our neural network analysis. In Figure 9B, the probability of DOW being higher than $54.54 is only 11.9 %, which means, roughly 11% of the time you will be correct if you buy 55 strike call. This is not the best strategy if you are bullish on DOW. You might be better off by paying more and buying 45 call option because there is a 71.64% probability of Dow Chemical being between and in the next 50 days. Also, you want to compare the Historical Volatility for the past 50 days with the Implied Volatility of the future and see if there is a discrepancy and what is happening in the underlying asset. Figure 9B Probability Calculator 26

28 When a certain event happens, you tend to do it over and over again, like rolling two dices in which there is a higher probability of landing a 5, 7 or an 8. In the same way, if you trade options over and over again, the 1 standard deviation of the stock being between certain points will be higher. 1 Standard Deviation for options helps determine Support and Resistance of the underlying stock based on Implied Volatility or Historical Volatility. 1 Standard Deviation can be defined as having a 68% probability of the stock reaching Strike Price (µ) by a certain date. So, (µ-1) is 1 Standard Deviation. (µ-2) is 2 standard deviations and, which means 95% of the time stock will be between the two key Price Points. Bollinger Bands is another technical indicator that you can use to make this prediction. We discuss Bollinger Bands and a number of other technical indicators in Section III on Developing a Trading Plan. 27

29 10 PICKING THE BEST STRIKE PRICE Time Range Selection is important when picking the right options with the optimal strike prices because the profit often hinges on the stock reaching the strike of the option by certain time. Probability Calculator helps determine the optimal strike prices for placing options trades. Figure 10 shows that the target price of $47.16 for Dow Chemical is $ Figure 10 Probability Calculator for Dow Chemical 28

30 On the other hand, if you are bullish on the stock, you can see the probability of the stock reaching $ If there is a 71.64% Probability of a stock reaching $54.54, and you are also bullish based on Tradespoon Analytics where Trend is 9 and Buy/Sell Rate is 8, then you can consider buying $47 call option. Strike Price selected is 47. What if you are bearish on the stock? You might buy 55 put options because you know that there is a 71.64% Probability of the stock being between $47.16 and $ Tradespoon will send you daily trade recommendations that includes the estimated move of the underlying asset and the expected price of the stock. Tradespoon Analytics also shows you day by day prediction of where the stock is going to be on the next day, the next 5 days, and the next 50 days. A Directional Bias, whether Bullish or Bearish, is important and keep an eye on volatility. Normally, higher the Volatility, the higher the premium of the options and that will also help determine your Strike Price selection. Technical Analysis or Tradespoon Predictive Analytics take into consideration and help with better quantifying Risk, Volatility, and Strike Price Selection. 29

31 11 PICKING THE BEST EXPIRATION DATE Expiration Date is one of the most important factors to consider when trading options. Expiration Date for options, just like Strike Price discussed in the previous section, is a derivative of the underlying assets. That is, you have to be correct on the direction of the underlying asset by a specific expiration date. For example, while buying an insurance on the house, the time period is usually for one year and that is the expiration date. Essentially, Expiration Date is the final moment that an option and, after that, it expires or ceases to exist. So, it is important to know when to close out an option or when to let it expire. When you look at the Probability Calculator and Statistical Analysis, you will notice that the best options to trade are monthly options, as they are more conservative in nature. If you use a neural network and other predictive analytics, the longer time you are allowing yourself, the more time you have to be correct of the direction of the market and the direction of the underlying stock. The probability calculator in Figure 10 (previous chapter) shows the estimated move that Dow Chemical is going to make, the support and resistance slides, and the results of the Tradespoon Analytics for a period of 50 days. Two very important aspects shown here are Trend and Buy/Sell Rating. The Trend value of 9 means that we are bullish on Dow Chemical. And Buy/Selling Rate of 8 means, looking at the technical fundamental analysis we are very bullish on the stock. Thus, as shown we can use the probability calculator to predict where the stock is heading during a certain time frame. Time Horizon is an important factor in this analysis. In order to be successful and benefit from options trading, you have to be correct on both time selection and direction. Tradespoon will provide you accurate analytics for predicting stock trade movement into the future. In Figure 11, you see both a ten day prediction and six months prediction. It shows where a stock or an option that you are trading is heading. In this particular 30

32 example you will see that the stock prices for Dow Chemical are going up. Keep in mind Volatility also impacts the timeframe that you are trading. Figure 11 Dow Chemical Long and Short-term Predictions Lastly, be aware of the difference between Short-Term Prediction and Long-Term Prediction. Some of our models are more accurate for short-term trading, while others like Tradespoon Ideas Bulls and Bears, are more accurate in predicting long-term stock prices. Match the strike prices and expiration months that offer the best risk/rewards given the timeframe being considered. 31

33 12 GETTING STARTED If you ve read this far, you are motivated to learn more about the financial markets, options trading, and how Tradespoon can help you become a smarter investor. So far, we have covered a lot information, but there is a lot more still. If you haven t yet, download the entire Tradespoon: Trade Smarter ebook. It covers more advanced topics like multi-leg options strategies, risk management, and technical analysis. Also sign up to Tradespoon Premium to begin using the Stock Forecasting Tool, the Probability Calculator, and Trade Ideas Scanner. You will begin receiving Tradespoon picks and, if you re not quite ready to trade, you can track the results live on the web site (see Figure 12). Feel free to contact us with any follow-up questions at info@tradespoon.com and Good Trading! Figure 12 Tracking Tradespoon Expert Picks 32

34 II ADVANCED OPTIONS STRATEGIES The first section of this book covered the basics of options trading and highlighted some of the tools available to Tradespoon subscribers, like the Probability Calculator, the Stock Market Forecasting Tool, and the Daily Tradepick. Now it s time to roll up our sleeves and dig into more advanced options material. We cover simple and advanced strategies, volatility, earnings plays, and unusual options activity scanners. The final section delves into technical analysis, chart patterns, trade psychology, and portfolio management. 33

35 13 BULL CALL SPREADS A Bull Call Spread involves buying a call option and selling a call option with a higher strike within the same expiration month. KEY CONCEPTS Cost Basis Reduction: Call Spread allows Cost Basis Reduction. This is the main reason why you want to trade verticals (spreads with different strike prices in the same expiration term). Moderate Upward Movement: It is executed when the general feeling towards an asset is positive and a moderate upward movement is expected. Suppose you are bullish on the Stock and expects it to move upwards but not in a rapid fashion, then you can trade Debit Call Spread. Low Risk, Low Reward and Lower Requirements: Debit Call Spread involves low Risk, has low Requirements and will provide low Reward. Trade gives up some upside potential in exchange for chance to recover premium. This higher Probability of Success compared to Long Calls is the most important aspect of Debit Call Spread. Here you will not only have a cost basis reduction, but also a higher Probability of Success compared to trading Calls. When you start trading options, you might be able to trade only in Puts and Calls as your broker or dealer might not give you enough rights to trade vertical spreads. But once you get more experienced and understand the concept of Probability of Success, you can ascribe for Cost Basis Reduction as you are buying calls and selling out-of-the-money calls in Debit Call Spread. By selling OTM calls with higher Strike Price Call, you can reduce the cost basis compared to when buying a call outright. And by reducing the cost basis, you can increase the probability of being correct. 34

36 SET UP Buy In-The-Money (ITM) Call Option with lower Strike Price, because you have a bullish bias for an underlying asset Sell Out-of-The-Money (OTM) Call Option with a higher Strike Price. Use the same underlying asset and the same contract Expiration Date based on Analytics accuracy. You have to pick an Expiration Date that gives you the highest chance of success. Based on our research at Tradespoon, the best duration for Option contract is between days. So, when you trading Options, for higher Probability of Success, you want to pick days till expiration-because they just gives you more time to be correct on your bias for the stock. Select Strike Prices based on Probability of Success, and Tradespoon Analytics such as Probability Calculator or Stock Forecast Tool. EXAMPLE In Figure 13, x-axis denotes the Stock Price and y-axis denotes the Profit/Loss. Point A denotes the buying price and Point B denotes the selling price, which are the Strike Price selections. The Expiration Month is again days. So, Maximum Loss will occur at Point A, meaning that if you are wrong and the stock drops to lower than point A, you will lose money. Maximum Gain occurs at Point B. The Breakeven Point is the Debit Price you paid and is indicated by the point where the blue line intercepts the x-axis. This example is of a directional trade with bullish bias. Figure 13 Bullish Call Spread 35

37 RETURN ON CAPITAL Return on Capital determines at what point you get into a position and at what point to get out of the position. With Bull Call Spreads you pay the cost of the Long Call (In-The-Money Option) and you earn proceeds from the sale of Short Call Option (Out-of-The-Money Option). Total trading costs is the difference between the amounts paid and earned under maximum Risk. Maximum Gain is the difference between the two Strike Prices (B-A) minus the original Debit paid. Maximum Loss will be the original Debit paid which is the sum of (A) and the premium paid for the Debit Spread. Breakeven Point is the position where maximum loss can occur and is at the point of intersection of the blue line on the x-axis. 36

38 14 BULL PUT SPREADS A Bull Put Spread involves selling a put and buying a put with a lower strike price within the same expiration month. KEY CONCEPTS Cost Basis Reduction: Put Spread also allows Cost Basis Reduction. Moderate Upward Movement: It too is executed when the general feeling towards an asset is positive and a moderate upward movement is expected. Low Risk, Low Reward and Lower Requirements: Again Debit Put Spread too involves low Risk, has low Requirements and will provide low Reward. And trade gives up some upside potential in exchange for chance to recover premium. Also there is higher Probability of Success compared to Long Calls, similar to Debit Call Spread. Here you will not only have a cost basis reduction, but also a higher Probability of Success in trading Calls. An important point to note is that, if you have a bullish bias and want to reduce the Cost Basis, you will have to execute Credit Put Spread. SET UP Sell At-The-Money (ATM) Put Option with a higher Strike Price. Buy Out-of-The-Money (OTM) Put Option as a hedge. Use the same underlying asset and the same contract Expiration Date based on Analytics accuracy. Select Strike Prices based on Probability of Success, and Tradespoon Analytics. 37

39 EXAMPLE The Profit and Loss graph for both Bullish Debit Call Spread and Bullish Credit Put Spread are absolutely identical. So again the x-axis denotes the Stock Price and y-axis denotes the Profit/Loss. Point A denotes the buying price and Point B denotes the selling price, which are the Strike Price selections. The Expiration Month is again days. So, Maximum Loss will occur at Point A, meaning that if you are wrong and the stock sells off lower than point A, you will lose money. Maximum Gain will occur at Point B. The Break Even Point is the Debit Price you paid and is indicated by the point where the blue line intercepts the x-axis. This example is of a directional trade with bullish bias. Figure 14 Bull Put Spread RETURN ON CAPITAL With Bull Put Spreads you pay the cost of the Long Put (Out-of-The-Money Option) and you earn proceeds from the sale of Short Put Option (At-The-Money Option). Capital required is the difference between the Strike Prices minus premium received. Maximum Gain occurs on reaching the higher Strike Price and is limited to the premium received. Maximum Loss is the difference between the Strike Prices minus the premium received. Break Even Point is again the point of intersection of the blue line on the x-axis. 38

40 15 BEAR CALL SPREADS A Credit Call Spread involves selling a call and buying a call with a higher strike price within the same expiration month. KEY CONCEPTS Cost Basis Reduction: Bearish Call Spreads also allow Cost Basis Reduction. Moderate Downward Movement: It is executed when the general feeling towards an asset is negative and a moderate downward movement is expected. Low Risk, Low Reward and Lower Requirements: Credit Call Spread involves low Risk, has low Requirements and will provide low Reward. Trade gives up some downside potential in exchange for chance to recover premium. The higher Probability of Success compared to Long Puts is the most important aspect of Credit Call Spread. If you have a bullish bias, you may be able to buy a Put, but by executing Credit Call Spreads, you can also reduce your cost basis and thus improve the Probability of Success. SET UP Sell In-The-Money (ITM) Call Option with a lower Strike Price. Buy Out-of-The-Money (OTM) Call Option with higher Strike Price. Use the same underlying asset and the same contract Expiration Date based on Analytics accuracy. Select Strike Prices based on Probability of Success, and Tradespoon Analytics. 39

41 EXAMPLE In Figure 15, x-axis denotes the Stock Price and y-axis denotes the Profit/Loss. Point B denotes the buying price and Point A denotes the selling price, which are the Strike Price selections. The Expiration Month is again days. So, Maximum Loss will occur at Point B, meaning that if you are wrong and the stock sells off lower than point A, you will lose money. Maximum Gain will occur at Point A. The Break Even Point is between Point A and B where blue line intercepts the x-axis. This example is of a directional trade with bearish bias. Figure 15 Bear Call Spread RETURN ON CAPITAL With Bear Call Spreads you pay the cost of the Long Call (Out-of-The-Money Option) and you earn proceeds from the sale of Short Call Option (In-The-Money Option). Total trading costs is the difference between the Strike Prices and the original amount earned at maximum Risk. Maximum Gain is limited to the original proceeds. Maximum Loss is the difference between the two Strike Prices minus the original Credit you receive. Breakeven Point is the middle point between the two Strike Prices where the blue line intercepts the x-axis. 40

42 16 BEAR PUT SPREADS A Bear Put Spread involves buying a put option and selling a put options with a lower strike within the same expiration month. KEY CONCEPTS Cost Basis Reduction: Bearish Put Spreads too allow Cost Basis Reduction. Moderate Downward Movement: It is also executed when the general feeling towards an asset is negative and a moderate downward movement is expected. Low Risk, Low Reward and Lower Requirements: Debit Put Spread also involves low Risk, has low Requirements and will provide low Reward. This allows you to participate in more expensive Stocks. Here too trade gives up some upside potential in exchange for chance to recover premium. Also there will be higher Probability of Success compared to Long Puts. Again it makes sense as you are selling OTM put, thus reducing the Capital Requirements and cost basis, and increasing the Probability of Success. SET UP Sell OTM Put Option with a lower Strike Price. Buy ITM Put Option with a higher Strike Price. Use the same underlying asset and the same contract Expiration Date based on Analytics accuracy. Select Strike Prices based on Probability of Success, and Tradespoon Analytics. 41

43 EXAMPLE In Figure 16, the x-axis denotes the Stock Price and y-axis denotes the Profit/Loss. Point B denotes the buying price and Point A denotes the selling price, which are the Strike Price selections. The Expiration Month is again days. So, Maximum Gain will occur at Point A and Maximum Loss will occur at Point B. The Break Even Point is between Point A and B and depends on how much Debit you paid. This is again a directional trade with a bearish bias. Figure 16 Bear Put Spread RETURN ON CAPITAL With Bear Put Spreads you pay the cost of the Long Put (At-the-money option) and you earn proceeds from the sale of Short Put Option (out-of-the-money option). Capital Required is the original Debit paid for the Spread. Maximum Gain is the difference between the two Strike Prices minus the original Debit paid. Maximum Loss is the original Debit paid. Breakeven Point again depends on how much premium you paid for the Spread, and will be somewhere between the Strike Prices where the blue line intercepts the x-axis. 42